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Published On: Wed, Feb 12th, 2014

Market Sectors and Indices

Market Sectors

For ease of reference, stock markets will group together particular types of shares. One way they do this is in market sectors, for instance having an energy sector for oil, gas and electricity generating companies, a technology sector for manufacturers of computers and other devices, and a retail sector for stores. This allows the investor to judge when they have a cross-section of the economy represented in their share holding, which is generally held to be a good thing in case any particular market sector has a downturn.

Some people will say that you should put your money where the growth industries are, and make sure you move it on to a different market sector when growth is slowing. Undoubtedly, if you could predict the markets perfectly this would make you more money than having a cross-section of industries. Though if you’re so good at predicting the future, I wonder why you’re reading this stock market guide?

Look, do you remember the dot-com bubble? At the end of the last century, everything to do with the Internet was turning to gold, and companies were being founded all over the place by young entrepreneurs. And it all crashed in the year 2000, with companies such as Pets.com disappearing completely, and Cisco losing 86% of its value, though surviving through to the present day. There were few exceptions, such as Amazon.com, but most companies’ values were hugely inflated and many investors lost a lot of money. So you can take a chance, or stick with a more solid strategy, diversifying your investments.

Another way that companies are sorted out in the markets is by size. The value of the company or its “capitalisation” is calculated by multiplying the number of shares on the market by the share price, and some of the largest companies are worth billions. These are called “large cap” companies, the next size down are called “mid-cap” companies, and somewhat inevitably the next size down are called “small caps”. Even these are still pretty large in normal terms, and there are a whole host of other public companies which are smaller still.

There is no precise definition for these different “cap” sizes, and of course the capitalisation required changes over time – £1 billion would have been a major company 50 years ago, but this is becoming more of a small-cap level nowadays. Often it’s a matter of convenience, for instance the hundred largest companies on the London Stock Exchange might be called large caps, and so on down to comply with the number of companies in each index, as explained in the next section.

The website Macroaxis which reports on US companies gives firms that are valued at more than $150 billion the title of megacaps, with conventional large caps being up to $50 billion, mid-caps being up to $5 billion, small caps being up to $500 million, micro caps up to $50 million, and nano caps being up to $5 million. These numbers seem ridiculously large, but you have to realise that the total global market capitalisation of all public companies was more than $50 trillion in 2007, just before the global economic setback.

Indices

Companies can be grouped together to form “indices”, which are the sum total of the prices of several different companies, sometimes including multiplying factors or “weightings”. These are supposed to represent the overall economy in various ways, and give a guide to how things are going. There are various ways in which the compilers of the indices decide on which stock prices to use and how to combine them, and the principle behind them all is that the index is supposed to reflect the company marketplace in general, or in a particular sector if it is a sector index.

For an example, the London Stock Exchange has the set of “footsie” (FTSE) indices. FTSE stands for Financial Times Stock Exchange, but this long title was dropped some years ago for the abbreviation, and now there is a company called the FTSE Group which is wholly owned by the London Stock Market and runs the indices. The main index that people refer to is the FTSE 100, and it combines the prices of the biggest 100 companies on the UK market, the large caps. The 250 next largest companies, mid-caps, make up the FTSE 250 index. You will also see the FTSE 350 index, and that is simply the top 100 and the top 250 companies taken together. The small-cap companies aren’t included on these major indices, but there are many other FTSE indices covering different markets and sizes of companies. For example, the FTSE Ordinary Share index is the top 30 companies, and the FTSE All Share Index includes all of the companies on the stock market.

Some markets choose to do it a different way. The famous American index is the Dow Jones Industrial Average (DJIA), often referred to simply as the “Dow”, and that only includes 30 companies, with their share prices combined together in carefully calculated proportions so that they are deemed to represent the overall economy. Although they are all large companies, they are not selected on basis of size but include a cross-section of market sectors to give a more general index. They are selected by the editorial staff of the Wall Street Journal, and the composite companies rarely change, although General Electric (GE) is the only company on the list that was there when the Dow started over 100 years ago. The Dow started in the 19th century as an index of major companies, but was soon split into the DJIA and the Dow Jones Transportation Average (DJTA), as railroads were a major section of the stock market at that time.

As with the FTSE, there are many more other indices associated with the Dow Jones name that cover various markets and types of shares. Some people choose to buy and sell “indices”, that is funds that represent the values of the indices, rather than deal in individual stocks. The funds will invest in the stocks in the proportions required to represent the index.

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About the Author

- Robert is a private trader with over 15 years experience trading the financial markets.

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